Quod Erat Demonstrandum

Some investors are looking for the falling sky, while other investors are passionately buying. Perhaps the truth is somewhere in between. However, many investors become anchored to a position, which, in the moment, hasn't yet been demonstrated. Thus the inspiration for this week's musings and the 1987

film, "No Way Out." Here’s some trivia about the movie:

• This film was not exactly a box office hit, earning just over $35 million on a $15 million budget. However, it was well-regarded by the critics, with the esteemed Roger Ebert giving the film a 4 out of 4 stars - rarified air from him.

• With the passing of Gene Hackman this week (one of my favorite and under-appreciated actors), he and fellow actor Kevin Costner would go on to star in other films together. They each won two Oscars: Costner for "Dances With Wolves" (Best Picture/Best Director), & Hackman for "The French Connection" (Best Actor) and "Unforgiven" (Best Supporting Actor).

• Mel Gibson and Patrick Swayze turned down Costner's role of Tom Ferrell.

• This film was early in the career of Costner. He even performed many of his own stunts in the film.

• Will Patton (another one of my favorite actors) would later star with both Costner and Hackman in "Wyatt Earp."

Here's what we've seen so far this week..

Quod Erat Demonstrandum (Q.E.D.)? Are we witnessing the beginning of a bear market or a consolidation event that will present new market leaders?

Sometimes we can get convinced of an outcome by looking at a piece of evidence without know all sides of the story. A great scene in "No Way Out" is when a picture (spoiler alert) of Costner's character (Tom Farrell) becomes visible through photographic analysis, which places him at the scene of a woman's murder. Costner's nemesis (Scott Pritchard), played by Will Patton, surmises that this means Farrell killed the woman and declares, "Quod Erat Demonstratum." This is Latin for "Thus it is demonstrated." I'm not so sure that's a conclusion we can come to yet in the markets. As we've already pointed out, February is one of the weakest months of the year for returns. In a post-election year, the first quarter of the year following an election is the weakest return, but positive at least 55% of the time, going back to 1950.

And yet, investors seem to be fretting about recent volatility. As we've pointed out, the VIX had been trading well below its historical average for the past two years. If we take a deeper dive into recent VIX performance versus prior bear market events, I'm not sure we can conclude that a bear market has begun. Compared to the 2000, 2007, and 2020 bear markets, the VIX has risen recently only about half as much as prior early bear markets. Equities, as represented by both the S&P 500 Index and the Nasdaq Composite Index, have fallen recently by less than those prior events. As a reminder the VIX got up to a level of 38 briefly in August of last year, only to settle much lower.

We have also not seen a spike in credit spreads have of yet. In prior bear market events, credit spreads will spike just prior to equities beginning to slide. So far, credit spreads, as shown by the orange line in the graph, have not jumped significantly and are still trading near 18-year lows. So, I'm not sure that really has been "demonstrated" by the recent move in equities, other than a normal consolidation tied to both seasonality and shakeup among market leaders.

Slight of Hand, Or Mystery? The irony of Tom Farrell's situation is that while he did not murder anyone, he is guilty of likely being a spy. In fact, the cover story that Pritchard makes up about a long suspected KGB spy in the Pentagon (spoiler alert) is actually Farrell. Sometimes we just need to look deeper at the evidence.

Equity markets had been trading higher for most of this morning as Nvidia's earnings have been well scrutinized. However, a slight shock in trading came after the Atlanta Fed dropped the update on Q1 GDPNow, an estimate of GDP for quarter-end. It showed the measure dropping from +2.3% to -1.5%. Markets seem to have absorbed the number so far. However, a deeper dive into the number shows an estimated decline in Net Exports from -0.41 last week to -3.7 this week. This is likely a response to tariffs which are soon to be enacted. Yet, if we look at when tariff wars arose during President Trump's previous administration, the numbers were pretty steady. It might be too early to estimate the outcome of new tariffs.

This morning's release of the Fed's preferred measure of inflation (PCE Price Index) showed little-to-no-change in January, both on a month-over-month basis and a year-over-year basis. This has probably provided market's with some comfort that perhaps another rate cut by the Fed could be back on the table for later this year. The Fed Futures for rate cuts has shifted slightly to show a 57% probability of one rate cut in June.

Overall, investors continue to purchase equities, especially large caps. Small caps and Cyclicals are losing ground - which would partly explain the pull back in over-valued tech names. However, previous metals and bonds are garnering inflows. It's no mystery that AI-related names pushed valuation metrics too high, but many other equities still offer value. Since peaking on December 18th of last year, the Mag 7 are down roughly 12%, while the S&P 500 Equal-Weighted Index is almost flat. Until credit spreads spike and or investors flee to safe havens, expect some better outcomes in March.

Q.E.D...

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